OC: Can you pl. give little more info. on what do you suggest? How should butterflies be used? if you can point to a docuemnt with examples, that will be great. Thanks,
There is a dan sheridan video at the CBOE website called something like "timebomb butterflies" that talks of using cheap OTM flies for directional and vol bets that can blow up in your favor if they hit.
Well atty is a FLY expert so I am sure he will correct any deficiencies in my answer. Butterflies are good to study because they force you to become familiair with greeks such as delta and vega and theta since all 3 are especially important for using Butterflies. Best way to being is to analyze a butterfly in relation to each Greek, and you can do it intuitively first without getting bogged down in the numbers. Volatility - A long fly needs the underlying to be as close as possible to the body at expiration for maximum profit and somewhere between the wings/breakeven points for any profit at all. To illustrate IV/vega consider an ATM long fly. A stock whose IV is relatively high is expected to have some relatively more volatile price fluctuations over the time remaining to expiration and therefore the liklihood that the stock will sit right at the ATM strike is relatively small. This small chance results in a small probability that the stock will be at the ATM strike at expiration and a small probability that the position will be profitable. Therefore the price of the FLY, holding all other things constant will be relatively low. If time stood still and IV suddenly dropped sharply, the market expectations of wild swings also drops and the probability that the stock will stay within the wings increases, thus making the ATM Fly more valuable and its price goes up. So if you have an option analyzer and look at an ATM Fly with relatively high volatility and then decrease or collapse vols, you will see the price of the FLY increase, holding all other factors constant. Thus you are seeing the nature of long FLYs in that they are short volatility by means of a hedged spread. In other words if you think vols are relatively high you can sell a short straddle and profit from a collapse in vols if the underlying stays still but you have high margin and short option risks. The long butterfly can acheive the same purpose since it is short vols by nature of its greeks but hedged to a net debit. Thus if you have an option analyzer and find a stock with vols at it upper historical IV ranges, put on an ATM FLY in the analyzer and asusme vols contract back to mean levels holding other factors constant and you will see how the value of the butterfly changes. This is a good exercise to understand the IV effects on FLYs and then you will get a better sense when it is better to use them or how to use vol to your advantage. I think from my example you can figure out the time decay and delta factors of a FLY and from there you can construct better positions. To give FLYs a bias you simply shift the body OTM in the direction of your bias. THis moves it from delta neutral to actually having + or - bias in addition to theta and vol considerations. I like to use FLYs as the best example to teach the greeks since once you can understand how a FLY is affected by these pricing factors, all other strategies are quite easy to relate to.
OC: Thanks for the info., agree taht these will force understand the greeks. C99: Yes, I checked the video on CBOE, nice one. I also noticed that the docuemt link I posted also has a mention of butterfly strategy. Thanks,